Fed hike to widen spreads Econoday International Perspectives 5/15/00 By Anne D. Picker, International Economist

The FOMC looms
Overseas equity markets sank nervously last week while marking time until the Federal Reserve Open Market Committee meeting on May 16^th and the expected interest rate increase. The markets recovered some of their losses when the United States reported that retail sales declined for the first time since mid 1998. The markets took this news to mean that inflationary pressures from the demand side would ease, reducing the need for the Federal Reserve to increase rates in large 50 basis point increments. However, the markets acknowledge that a 50 basis point rate increase is already factored into the markets for May 16^th.

Britain and Europe
The London, Frankfurt and Paris equities markets suffered interest rate angst last week, only recovering after U.S. equities markets rose. Paris and Frankfurt particularly felt the sting of disappointment from Ecofin's (economic and finance ministers of the European Union) weak statement on the euro. Disappointing economic numbers for German manufacturing did not help either. By the time the good U.S. news kicked it, it was too late to salvage the CAC and DAX. Only the FTSE 100 managed to eke out an increase when compared with the previous week.

For the FTSE 100, help on Thursday and Friday came from lower than expected U.S. retail sales and a relatively benign producer price index report. Rising U.S. markets spurred overseas markets to overcome some of their inflation and interest rate fears and put a positive spin on the weeks' close. Overall, London markets were cautious as investors digested the Bank of England's Inflation Report and looked forward to the U.S. Federal Reserve's crucial interest rate decision next week. Another factor that helped was renewed weakness for the pound sterling. Sterling fell below $1.50 for the first time in four years, and remained below that level for a short period of time. The weakness followed the Inflation Report, which appeared to suggest that UK rates could be approaching the top of the current cycle.

The DAX and CAC, despite positive closes on Thursday and Friday, were not able to recoup losses earlier in the week. The DAX fell a hefty 261.54 points or 3.47 percent to end the week at 7269.28. The CAC lost 96.49 points or 1.47 percent to close the week at 6449.27. Despite the losses, both the DAX and CAC are among the very few equity indexes that are still positive this year.

Asia
The Nikkei 225 index lost 1,081.5 points or 5.87 percent to end the week at 17,357.86. Before recovering on Friday, the index sank to lows not seen since September 1999. But much of the drop is due to last month's reshuffling of the Nikkei's component companies. This forced many investors to sell the stocks withdrawn from the index while purchasing other shares that were included. The change has not yet been completely absorbed by investors as they reallocate their portfolios.

In the past year, foreign investors have been big supporters of the Japanese stock market. However, overseas investors have been retreating from Japanese stocks in recent weeks. In the six weeks to April 21^st, according to the latest available statistics, they sold a net $7.99 billion of Japanese stocks. That's almost triple the net selling by foreigners in all of 1998, when their distaste for Japanese stocks helped push the market to a 12-year low.

The Hong Kong Hang Seng index lost 138.19 points or 0.91 percent to end the holiday shortened week at 15,130.45, down 19 percent from its record on March 10. Stocks in Hong Kong closely track the rise and fall of their counterparts in the United States. The Hong Kong dollar is pegged to the U.S. dollar, and U.S. interest rate changes are immediately reflected in Hong Kong's interest rates. Investors are concerned that the recovery from the Asian crisis is still not strong enough to withstand higher rates.

Currencies
Euro perils (continued)
The foreign exchange markets were disappointed when the Ecofin finance ministers, after their Brussels meeting on Monday, failed to deliver a strong statement in support of the euro. The ministers issued what many traders believed was a tepid one stating simply that they "share a common concern about the present level of the euro, which does not reflect the strong economic fundamentals of the euro area." Although several officials later said intervention remained a weapon in the European Central Bank's arsenal, the statement contained no mention of the possibility of such action.

Traders then focused on Thursday's European Central Bank Governing Council meeting and the press conference that followed for clues about the council's level of discomfort with current exchange rates. The euro stabilized around $0.90 on concern that intervention was in the works. A trader said the market was getting bored with official intervention rhetoric and the central banks would have to do something soon to remain believable. But hopes were disappointed after the European Central Bank clung to the status quo leaving interest rates unchanged. ECB president Wim Duisenberg offered only the familiar rhetoric that the euro's value did not reflect strong European economic fundamentals.

However, the euro did rally on Friday but only after weak U.S. retail sales data on Thursday was combined with relatively benign producer price data on Friday. Traders decided that perhaps the U.S. economy is slowing and interest rates would not have to be raised as much as originally thought. The euro ended the week just under $0.92 at $0.9190.

Yen resists gravity
The theory that equity outflows were propelling recent yen weakness was given credence by a report in Nikkei's interactive edition which quoted Tokyo Stock Exchange data showing foreign investors were net sellers of Japanese stocks in April at a pace not seen in the last ten years. However, when the yen rose above 110 to the dollar, exporters stepped in once again to repatriate earnings and pushed the yen up to 108.45.

Crude Oil prices are drifting upward
Crude oil futures prices have been creeping up on indications that supply would be tightening despite the increased OPEC output. On Friday, crude futures rose over the key $30 level for the first time in two months, but retreated to close at $29.61. The May International Energy Agency oil market report stated that lower demand and higher supplies have relaxed the projected second quarter balance. However, with the summer driving season almost here and world demand increasing, demand growth from June onwards is expected to tilt the balance back to a tighter market. The prediction for tighter supplies sent crude prices higher.

Prices hit the $30 mark after three major oil producers said they currently see no need for a hike in world oil production. Late Thursday, oil ministers from Saudi Arabia and Venezuela and Mexico said that no further action is needed in world oil markets as crude supplies have reached more satisfactory levels. They did add that they are keeping the window open for further changes in policy should the markets demand them. However, prices dropped back in afternoon trading, pressured by a Mexican oil minister's doubt that crude prices would remain above $29 a barrel.

The ECB meets and does nothing
The European Central Bank decided to leave its main policy making refinancing rate unchanged at 3.75 percent at its Governing Council meeting Thursday. The ECB has raised interest rates by a total of 125 basis points in four steps since November with the most recent 25 basis point increase occurring on April 27^th.

At the regularly scheduled press conference immediately after the meeting, ECB president Wim Duisenberg reiterated that the prime focus of monetary policy was inflation control. He also said that the euro continues to be undervalued. The euro ebbed lower after the press conference when foreign exchange market participants were not satisfied with his comments about the euro.

Indicator scoreboard
Britain - April seasonally adjusted input prices dropped 3.2 percent. When compared with last year the annual rate of input price inflation rose 7.1 percent. The monthly drop was the largest since the series began in January 1986 and primarily reflects the sharp drop in crude oil prices over the month. These fell by an unadjusted 18.5 percent over the month but were still up 50.2 percent on the year. Seasonally adjusted core output prices (excluding food, beverages, tobacco and petroleum) rose by 0.1 percent on the month and 0.8 percent when compared with last year - still the highest since December 1996.

March manufacturing output rose 0.4 percent and 1.6 percent when compared with year. In the first quarter, manufacturing output fell by 0.5 percent but was up 1.6 percent on the year. March production industries' output rose 0.5 percent on the month and 1.3 percent on the year. First quarter total industrial output fell by 0.8 percent on the quarter and was up 1.4 percent on the year.

Germany - March seasonally adjusted industrial production declined 2.5 percent. The March decline was led by a 15.5 percent drop in construction output. Manufacturing output fell only 0.9 percent. The March decline was mainly due to strong decreases in intermediate goods (-2.4 percent) and consumer goods (-1.6 percent). Capital goods, however, rose 1.3 percent and durable goods were up 0.2 percent on the month. In west Germany, output fell 1.6 percent on the month while in the east, output was down 10.7 percent.

April seasonally adjusted unemployment rate declined to 9.6 percent, down from 10.1 percent in March. The seasonally adjusted unemployment rate in the west declined to 7.8 percent from 8.2 percent while that in the east it fell to 17.3 percent from 17.6 percent. April's unemployment rate is at the lowest level since September 1995. Though falling, German unemployment is still above March's average of 9.4 percent for the 11 EMU nations. It's also well above the U.S., where April's 3.9 percent rate was at a 30 year low.

March seasonally adjusted exports were up 6.7 percent on the month while imports were up 7.0 percent on the month. The data are adjusted for seasonal variations but not for inflation.

Asia
Australia - March seasonally adjusted retail sales rose 0.6 percent. In real terms, retail sales were down 1.5 percent in the first quarter after a 1.1 percent jump in the fourth quarter of last year, suggesting that the economy is slowing down.

April unemployment rate fell to 6.8 percent, down from 6.9 percent in March. The participation rate was 63.7 percent. The number of employed rose 37,400 in April from March.

Japan - Revised real fourth quarter gross domestic product contracted 1.4 percent. GDP dropped at an annualized rate of 5.6 percent. Non-residential private capital expenditures were up 4.6 percent, and domestic demand was down 1.0 percent. Private consumption was down 1.6 percent in the fourth quarter from the previous quarter. Private investment in housing was unchanged at down 5.8 percent.

April domestic wholesale price index was down 0.1 percent but rose 0.5 percent when compared with the previous year. Edible agricultural products prices fell while petroleum and coal products and chemicals rose. The April export price index fell 0.1 percent in terms of contract currencies and was down 0.1 percent in yen terms. On the year, export prices were down 7.9 percent in terms of the yen, reflecting the rise of the yen over the year. The April import price index fell 0.1 percent in terms of contract currencies and was down 1.0 percent in yen terms. On the year, the index was down 2.2 percent in yen terms.

March household spending fell 4.3 percent on a real basis and 4.9 percent in nominal terms when compared with the previous year. The average monthly income fell 4.1 percent in nominal terms and was down 3.5 percent in real terms. Living expenditures fell 1.9 percent in nominal and 1.3 percent in real terms when compared with the previous year.

BOTTOM LINE
Investors are concerned an increase in U.S. interest rates will dampen foreign investors' appetite for the global equity market. Analysts expect the U.S. Federal Reserve to raise rates by at least 25 basis points and probably 50 basis points when the FOMC meets Tuesday. Higher rates in the U.S. might force up borrowing costs in countries closely linked to the dollar, slowing economic growth and eroding corporate profits.

Of importance are interest rate spreads between countries. The current spread between the United State and the European Monetary Union is 2.25 percentage points. Should the Fed raise overnight rates to 6.5 percent from 6 percent, the spread would jump to 2.75 percentage points, making U.S. investments even more attractive then they already are. As long as the spread remains this wide, European investors will continue to invest in the United States, placing downward pressure on the euro because of increased demand for dollars.

Looking Ahead: May 15 to May 19, 2000